The majority of investors have completely missed the rally in energy stocks that has ensued over the past four months. As a result, there is a certain amount of performance anxiety among portfolio managers who continue to see oil stocks rising.

That’s prompting some money to come off the sidelines and into the sector. But as Eric Nuttall, portfolio manager at Sprott Asset Management sees it, the situation is a lot like elephants going through a keyhole.

“As that money has been flowing in, it’s inflating valuations in certain pockets of the market,” he said. “Once you have the collective investment community go from underweight to market weight energy, then I think there will be a re-emergence of a focus on valuation and an epiphany that perhaps some of these stocks have run too far relative to where the price of oil is likely to go.”

Nuttall thinks that will be around US$60 to US$65 per barrel next year, and therefore sees a temporary pause coming for energy stocks.

That’s why he only owns six names of meaningful size in the $90 million Sprott Energy Fund, and has a cash weighting of roughly 65 per cent.

Nuttall was fully invested in December and January, making for a very painful period. But that decision to go all-in paid off when the energy market rallied, and the fund is up 33.88 per cent year-to-date as of May 11.

His success came from identifying companies that the market was viewing as inevitably bankrupt given their excessive debt.

Baytex Energy Corp. (BTE/TSX) was one name that had fallen more than 90 per cent (he doesn’t own it anymore). Yet a closer look at its debt showed that it wasn’t coming due until 2021, and as long as the company could make its interest payments and stay onside of the small covenants it had with limited bank debt, it would survive the period of low oil prices.

“Those types of names have done phenomenally well, so the risk-reward in some of them is not as compelling,” Nuttall said. “The market is already embedding a certain recovery in the price of oil.”

Peter J. Thompson/National Post

Up until the recent rally, much of the capital was hiding in large cap energy stocks. Nuttall noted that the group was trading at some of the most expensive multiples in history, relative to both current oil prices and futures, which were in the US$50s for the next five years.

“The large caps are unquestionably overvalued, so the best opportunities are still in the mid-cap space,” he said. “But I prefer not just financial leverage, but product leverage — the type of oil a company is producing.”

One of Nuttall’s larger holdings is Cardinal Energy Ltd. (CJ/TSX), which produces medium-gravity oil that sells at a discount to light oil.

“The stock fell more than others because of this issue,” he said. “As the market is becoming more optimistic on the price of oil, what caused that stock to fall more than others should cause it to rally more than others.”

Nuttall’s short-term tactical call shouldn’t be mistaken for a bearish outlook for oil.

He noted that the financial market for the commodity is about 30 times the size of the physical market, making it easy for the underlying fundamentals to be distorted.

“It can take the price significantly lower than it ever should as dictated by supply and demand, because it is all being dictated by sentiment,” Nuttall said. “Sentiment got significantly worse than what anyone thought was possible.”

He believes we’re months away from showing the oil market is undersupplied, which will come in the form of inventory draw-downs in the U.S.

“We’re finally at the point now where not only have companies dialled back spending materially, and we know that is significantly below where production stays flat, but at the same time banks are enforcing the discipline on oil executives,” Nuttall said, adding that debt to EBITDA among U.S. companies is roughly 4.4x, compared to a historical average closer to 1.5x.

He also noted that banks are under pressure from shareholders to reduce their exposure to the energy patch, which means that any excess cash being generated is not going into the ground, but rather, it’s going back to the bank.

With the U.S. rig count as much as 80 per cent below where it needs to be to keep production flat, Nuttall thinks oil needs to be at US$50, US$55 or maybe even US$60 – and stay there – before there is a large uptick in the U.S. rig count.

He also pointed out that U.S. production is down about 700,000 barrels per day from the peak of March-April 2015, yet demand is growing by 1.2 million barrels per day.

“When you look globally, outside of Iran, there is really no significant pockets of production growth because the price has fallen to a point where it is completely uneconomic for the majority of OPEC and non-OPEC,” Nuttall said. “There is also a belief that we are going to be awash in oil between US$45 and US$50 because it is such a wonderfully profitable business at that price level, and the U.S. oil machine will come back and drill. I think that is preposterous.”